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10 Ways to Reduce Your Estate Taxes

September 6, 2023.

10 Ways to Reduce Your Estate Taxes

 

  1. Marital Transfers:

Neither lifetime gifts nor bequests in a will are subject to estate taxes if these assets transfer to a surviving spouse. The exception is if the spouse is not a U.S. citizen.

The marital transfer estate tax exemption can defer payments owed to the IRS. The exemption does not eliminate estate taxes, though. It only puts off the tax bill the estate may face.

When the second spouse dies, the estate owes taxes on the entire taxable estate. This includes the assets transferred upon the first spouse’s death.

 

  1. Lifetime Gifts to Children and Grandchildren:

Each member of a married couple can make annual, tax-free gifts to an unlimited number of people each year.  The 2024 limit is $18,000 per recipient. If both spouses engage in gifting, they could collectively give away their combined exemption amount each year (which is $36,000 in 2024) to each recipient.  If gifts to an individual in any year exceed this amount, they will eat into a person’s lifetime exemption (which is $13.61 million for 2024).  Cumulative gifts/asset transfers that exceed the lifetime exemption are subject to gift and/or estate taxes.

 

  1. Gifting to Minors:

There are ways to gift to minors without incurring gift tax consequences. You may make gifts according to the Uniform Transfers to Minors Act using custodial accounts that are controlled by state law.

When states adopt a model law, such as UTMA, they often make minor changes to the statute. The Gifts to Minors rules apply until recipients turn 18 or 21, depending on where they live.

UTMA allows a minor child to receive money or real property. The nature of the property that can be gifted or transferred to minors under the law is expansive. Specifically, these gifts could include:

  • Real estate
  • Royalties
  • Patents
  • Valuable artwork
  • Antiques
  • Cash
  • Securities

Assets held in these types of accounts may be managed by the grantor (donor) or by a custodian named by the grantor. The IRS allows an exclusion from gift tax up to the annual exclusion limit ($18,000 in 2024).

Any gift exceeding the annual exclusion limit is taxed at the minor’s tax rate. Earnings from these accounts are also taxed.

This method of gifting does have a drawback: It can impact student financial aid qualifications.

 

  1. Marital Trusts (AB Trusts and QTIP Trusts):

As mentioned previously, the personal estate tax exemption is $13.61 million, as of 2024, means you can transfer assets with a market value of up to $13.61 million before owing estate tax at the applicable federal rate.

Two types of trusts can be used exclusively by married couples for estate tax planning. Each type of marital trust allows a spouse to use that personal estate tax exemption to the fullest extent. These AB and QTIP trusts do not disadvantage the surviving spouse.

Each spouse can transfer their separate assets and share of community property assets into a living trust. These assets benefit the surviving spouse. The grantor spouse retains control over the ultimate disposition of those assets at the time of the second spouse’s death.

The surviving spouse can use the late spouse’s property for the remainder of the survivor’s lifetime. They can use the personal property in the trust as defined in the trust document.

Here’s where the difference comes in:

  • An AB trust allows the surviving spouse to access the interest earned and, in some situations, the trust’s principal investment.
  • A QTIP trust, on the other hand, does not allow the spouse to access the assets.

As such, a QTIP trust tends to be popular when the donor spouse is married for a second or subsequent time and has children from a first marriage. The children from the first marriage will inherit their parent’s assets. An AB trust may be more common when there are only children from a single marriage.

 

  1. Irrevocable Life Insurance Trust (ILIT):

A life insurance trust is a financial planning tool with various tax benefits. Funds transferred into the life insurance trust pay premiums for one or more life insurance policies. These could be:

  • A term policy
  • A whole life policy
  • A second-to-die policy

When the donor dies, the trust inherits the life insurance proceeds or any death benefit, not the estate. Assets distributed through the trust are not subject to estate taxes.

Among its many benefits, an irrevocable life insurance trust can reduce state and federal taxes owed on a tax return during life. Additionally, an ILIT can avoid estate taxes after death while allowing the donor to control the timing and distribution of an inheritance in the trust.

 

  1. Family Limited Partnership:

A family limited partnership is an estate planning tool for families with business interests. It is a family-owned holding company, which can be set up as a limited partnership (LP) or a limited liability company (LLC).

A family limited partnership:

  • Minimizes income tax
  • Ensures continuity of business ownership
  • Limits liability for family partners

The family limited partnership has two classes of owners: the general partners and the second-class owners.

  • The general partners are typically the people who set up the partnership and own and manage the business. The general owners are typically the parents or grandparents.
  • The second-class owners are limited partners or passive owners. Second-class owners are generally the children and grandchildren of the general partners.

The general partners put assets into the partnership and then gift an interest or share in the partnership to family members. Because that share can’t be sold to anyone other than a family member, it lacks marketability.  The value of such an interest can be discounted by 15% to 30% in value. That discount alone can help to avoid paying federal estate tax.

Suppose that a limited partner has a lot of debt. Can they raid the family partnership to pay their bills? They cannot, as the limited partner has no control of or access to the partnership unless the general partners allow it.

Assets in the partnership are protected until they are distributed. Partners are responsible for paying income tax on their share of income from the business of the family limited partnership. Growth in the value of assets in the family limited partnership is also free of inheritance tax and estate tax.

When the general partners are ready to transfer control, they can decide who will receive their interest. It could be a family member or a trustee.

 

  1. Private Annuity:

A private annuity results from selling an asset to (usually) a younger family member. It is sold in exchange for a promise to pay annual amounts to the seller (also called an annuitant) for the seller’s lifetime.

The asset is no longer part of the seller’s estate. Thus, the value of their estate is reduced. The buyer’s annuity payments become part of the seller’s estate.

 

  1. Special Use Real Estate Valuation:

For federal estate tax purposes, real estate is usually valued at its “highest and best use.” This can sometimes produce undesirable results, such as when a family farm is adjacent to more valuable commercial real estate.

To address this, the Internal Revenue Code permits certain real estate to be valued for its “actual use” rather than its “highest and best use.” This is known as special use valuation. This special use valuation can result in substantial tax savings.

 

  1. Qualified Personal Residence Trust (QPRT):

A grantor can use a QPRT to transfer a home to their spouse after they die. These trusts allow the second spouse to remain in the house until their own death. A qualified personal residence trust allows both homeowners to put any primary or secondary residence in their name into a trust. At the same time, it enables the grantors to continue living in the house for a set number of years.

If the home increases in value during the owner’s lifetime, the amount of the increase will not be added to the home’s value when the house is gifted to children or other beneficiaries. This can be a boon if you live in a state with quickly appreciating property values, and it can reduce the amount of gift tax on the estate as a result.

A QPRT is not, however, without risk. If the grantor-homeowners die before the end of the trust, there will be no tax savings for the trust beneficiaries.

 

  1. Charitable Trusts and Charitable Transfers:

Lifetime charitable transfers or gifts to charities upon death can reduce the value of your estate and thereby reduce estate taxes. Lifetime gifts may provide the added benefit of an income tax deduction. Charitable remainder trusts are the most common type of charitable trust.

A donor can structure gifts to allow the donor to retain the right to use the gifted asset or income until their death.

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References

Harton, Oni.  “10 Ways to Reduce Estate Taxes.”  10 Ways To Reduce Estate Taxes – FindLaw.  September 6, 2023.

 

The information in this article is general in nature and for informational purposes only.  None of this information is intended to be personalized (and tailored to an individual’s unique circumstances) and should never be construed as specific tax, legal or financial recommendations.  Before making any financial decisions, you are strongly encouraged to first consult with a qualified financial professional.

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